# Marginal and Absorption Costing by auu87272

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Marginal and
Absorption Costing
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Marginal
and Absorption                                                                    1
Costing

The cost per unit of an item is important for
• setting the selling price
• valuing stocks
• calculating profitability.

Marginal costing

The cost of an item includes only the variable costs incurred in its production. For example,
Material components used and piece-rate assembly labour costs.

Accounting entries

As costs are incurred (e.g. materials)
Dr Material Stock Account
Cr Creditors (or cash) Account
As materials are issued to production
Dr Process 1 Account
Cr Material Stock Account
Direct labour costs are treated similarly.
Fixed production overheads are taken straight to the P&L at the year end.

Absorption costing

The cost of an item includes the variable costs incurred in its production and a proportion
Thus,
absorption cost (AC)     marginal cost (MC)     some fixed overhead (FO)

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4 Exam Practice Kit: Performance Evaluation

The fixed overhead per unit is the absorption rate (FOAR).
Possible bases (methods) for sharing out the fixed overheads include
•     units
•     labour hours
•     machine hours
•     material usage.

Accounting entries

All variable production costs are recorded as for marginal costing.
In addition, the fixed overhead per unit is transferred to the process account.
This gives rise to an under or over absorption of fixed overheads; that is, a balance on the
fixed overhead account which is taken to the profit and loss account.

Reconciliation: marginal costing and absorption costing

Marginal costing profit and absorption costing profit are the same apart from the impact of
They can be reconciled thus
Profit per AC                           £x
Add: FO in opening stock                £x
Less: FO in closing stock               £(x)
Profit per MC                           £xx

Comparison: MC vs AC

MC                                                               AC
Good for short-term decision-making               Consistent with external accounting
Profit not distorted by stock policy              Prices must cover all costs
Treats fixed costs as period costs                Highlights total cost of producing

Questions
1.1    A company has budgeted production of 500 X’s and 300 Y’s next year. Y’s take twice
as long to make as X’s.
Total fixed overheads are expected to be £102,000.
Costs relating to the X are budgeted at
Materials:             3,000 kg           £24,000
Labour:                2,000 hours        £40,000
Fixed overheads are to be absorbed on an hourly basis.
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Marginal and Absorption Costing 5

In addition to the above some material normally goes to waste, this is expected to
amount to 10% of materials purchased.
What is the absorption cost per unit of X?
A   £225.52
B   £226.05
C   £260.30
D   £260.83
(4 marks)

1.2   A company’s production and sales were budgeted at 300 units.
Actual production was 315 but sales were only 295.
The marginal cost profit was

£                 £
Sales                                         64,900
COS
Materials                  15,750
Labour                     15,750
31,500
Closing stock               2,000
29,500
35,400
Net profit                                    26,400

All costs were in line with expectations.
There was no opening stock.
What would the under/over absorption of overheads have been if the company had
used absorption costing?
A   £150      Under absorbed
B   £150      Over absorbed
C   £450      Under absorbed
D   £450      Over absorbed
(2 marks)

1.3   A company is considering improving its quality system leading to an improved repu-
tation and eventually a higher selling price.
Its current costs are shown below:

Old system           New system
Total demand                                3,600 units          3,600 units
Defective production                        20%                  10%
Labour cost per unit produced               £35                  £43
Total material per unit                     3.2 kg               3.5 kg
Price per kg of material                    £3.20                £3.95
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6 Exam Practice Kit: Performance Evaluation

Which of the following is closest to the increase in selling price needed to justify this
change?
A    £3.20
B    £9.80
C    £11.40
D    £15.00
(4 marks)
1.4   A company budgeted to produce and sell equal numbers of units. In fact production
was above budget whilst sales were below budget.
Which of the following statements about marginal costing and absorption costing
profits is most likely to be true?
A    absorption costing profits will be higher than marginal costing profits
B    absorption costing profits will be equal to marginal costing profits
C    absorption costing profits will be lower than marginal costing profits
D    absorption costing profits could be higher or lower or equal to marginal costing
profits
(2 marks)
1.5   The following are claimed to be advantages of marginal costing over absorption costing.
(i) Marginal costing avoids arbitrary sharing of costs.
(ii) Marginal costing is better for short-term decision-making.
(iii) Marginal costing avoids profit distortions due to stock fluctuations.
Which of these claims are substantially true?
A    (i) and (ii) only
B    (ii) and (iii) only
C    (i) and (iii) only
D    all of them
(2 marks)
1.6   The following details have been extracted from the budget papers of LK plc for June
2003:
Selling price per unit                       £124
Variable production costs per unit           £54
Fixed production costs per unit              £36
Other variable costs per unit                £12
Sales volume                                 12,500 units
Production volume                            13,250 units
Opening stock of finished items              980 units
If budgeted profit statements were prepared by using absorption costing and then by
using marginal costing,
A    marginal costing profits would be higher by £27,000.
B    absorption costing profits would be higher by £27,000.
C    absorption costing profits would be higher by £35,000.
D    absorption costing profits would be higher by £62,000.
(2 marks)
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Marginal and Absorption Costing 7

1.7   The following are the results of last year’s production.
Budgeted production 4,000 units
Actual production 3,800 units

What is the over/under absorption?
A   £500 under absorption
B   £500 over absorption
C   £900 under absorption
D   £900 over absorption
(2 marks)

1.8   A company’s cost card is shown below.

£
Materials                      10
Labour                         15
33
Variable selling costs          7
40
Selling price                  50
Profit                         10

Last year 4,000 units were produced, of which 3,750 were sold. Actual fixed overheads
were £28,000. There was no opening stock.
Calculate the profits under marginal costing and absorption costing, and reconcile
them.
(5 marks)

1.9   In what situations is absorption costing more appropriate than marginal costing?
Are there any situations where marginal costing is more appropriate?
(5 marks)

1.1   B
Note that material cost given represents only 90% of total costs and must be increased
by a factor of 10/9.
The overheads must be shared between the products using labour hours (2,000     500
4 hours for an X and therefore 8 hours for a Y).
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£
Material cost: £24,000 10/9 £26,667
Per unit (£26,667 500)                                  53.33
Labour cost per unit (£40,000 500)                            80.00
FO per unit
Total hours: X Y
500 4 hours 300 8 hours 4,400 hours
Overheads per hour: £102,000 4,400 £23.18
Per unit of X (£23.18 4 hours)                          92.72
AC per unit                                                  226.05   B

If you simply added 10% to the material cost then it comes to £52.80 (reducing overall
cost to £225.52 A).
If you used units to absorb the overheads this gives £127.50 per unit (increasing over-
all cost to £260.83 D).
Both of these errors give £260.30        C.

1.2   D
Overheads would be over absorbed since actual production was higher than
budget.
Remember to use production as a basis for absorption, not sales.
Budgeted FO per unit           £9,000   300 units   £30.00

£
Absorbed (£30.00        315)            9,450
Spent                                   9,000
Over absorbed                             450   D

If you use sales to absorb then you would calculate an under absorption of
£30.00 295 £9,000 £150 A.

1.3   B
In the following only the workings for the old system are shown. The new system
would be similar.
Remember that if sales are to be 3,600 units and 20% of production is defective
then only 80% of production is available to be sold. Total production needs to be
100/80 3,600 4,500 units.
If you calculate defects as 20% 3,600 720 and total production as 3,600 720
4,320, then when you lose 20% 4,320 864 there are only 4,320 864 3,456 avail-
able for sale.
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Marginal and Absorption Costing 9

Old system       New system
Total demand                                                       3,600 units      3,600 units
Defective production                                               20%              10%
Total production required (3,600            100/80)                4,500 units      4,000 units
Labour cost (£35 4,500)                                            £157,500         £172,000
Material cost (4,500 3.2 kg             £3.20)                      £46,080          £55,300
Total costs (157,500 46,080             18,000)                    £221,580         £256,860
Cost per unit (221,580       3,600)                                  £61.55           £71.35
Increase in cost per unit      £71.35       £61.55        £9.80.

1.4   A
In this case stocks will rise and thus absorption costing will carry forward some
Thus absorption costing profits will be higher.

1.5   D
All of these are true.
(i) Absorption costing has to share fixed costs in an arbitrary manner.
(ii) Selling prices need to exceed only variable costs in the short term.
(iii) Absorption costing causes profit distortions with stock fluctuations.

1.6   B
Remember that profits will be higher under AC since production sales and so some
of this year’s overheads will be carried forward in stock and charged against next
year’s income.
It is only production overheads that this applies to.
Increase in stocks 13,250           12,500 750 units
Extra overheads c/f 750             £36 £27,000 B.

1.7   C
Always work out the absorption rate before you start an absorption costing
question.
Absorption rate     £8,000/4,000           £2 per unit
Total overhead absorbed           £2     3,800 units        £7,600
Total amount spent         £8,500
Under absorption         £8,500        £7,600     £900.

1.8   Remember to value stocks correctly: include the fixed overheads only in absorption
costing.
Marginal cost     £25, absorption cost            £33
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10    Exam Practice Kit: Performance Evaluation

Unit                   MC                         AC
£             £               £            £             £
Sales                     50                          187,500                    187,500
COS
Materials                 10           40,000                     40,000
Labour                    15           60,000                     60,000
FO                        0/8            –                        32,000
100,000                    132,000
Closing stock             25/33        (6,250)                    (8,250)
93,750                    123,750
93,750                     63,750
FO                                                    (28,000)
Over absorption                                                                    4,000
65,750                     67,750
Selling costs             7                           (26,250)                   (26,250)
Profit                                                 39,500                     41,500
Reconciliation
£
Profit per AC                                         41,500
Less: FO in closing stock (£8     250 units)          (2,000)
Profit per MC                                         39,500
1.9   Absorption costing is more appropriate in the following situations.
•   Long-run pricing. In the long run both marginal costs and overheads need to be
covered, using absorption costing ensures this will be so.
•   Financial accounting. The standardisation of external reporting requirements
requires that a reasonable proportion of overheads be included in stock valuations.
Many companies want the external and internal accounts to reveal the same level
of profits.
Where there is only one product the overheads are clearly attributable to that product
and the overhead per unit figure is fairly non-controversial.
Marginal costing may be more appropriate where stock building is to be discouraged.
This is because absorption costing tends to boost reported profits when stocks rise,
encouraging managers to stock build.
Marginal costing is also more appropriate for short-run pricing decisions since any
selling price that covers the marginal costing leads to an increase in contribution and
hence profit.

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